Greenspan's Needle

W hen Federal Reserve Chairman Alan Greenspan testified before the Senate Banking Committee on Thursday, he made no mention of the stock market save for noting that the unsustainable pace of increase in household wealth had slowed, due to the flattening of equity prices. And while the Fed's six rate hikes over the past 12 months certainly have played a role in the stock market's slowdown, the chairman didn't 'fess up to targeting the market with monetary policy.

In private, however, his remarks have been as pointed as the needle he used to prick the market balloon. Indeed, recently released transcripts of Federal Open Market Committee meetings show that the Fed has been targeting equity prices since early 1994, when the Dow Jones Industrial Average stood around 3900.

Then, as now, the Fed Chairman indicated he was fighting expected inflation. But Greenspan's private words show another motive for doubling rates in 1994-95. And those words are likely a good proxy for the thinking behind the recent -- and likely unfinished -- round of tightenings. In the February, March, April and May 1994 meetings and phone conferences, Greenspan explained the need to prick the "bubble" in the stock market, to let the air out slowly and to produce uncertainty to curb speculation in financial assets. No such motives, however, were ever officially expressed -- and with good reason.

After all, the Full Employment and Balanced Growth Act of 1978 sets the Fed's "goals of maximum employment, stable prices, and moderate long-term interest rates." These goals were drawn from the Employment Act of 1946, which instructs federal government entities to "promote maximum employment, production and purchasing power." In both cases, what was to be stabilized were the prices of goods and services-not stocks.

But concern over rising equity prices clearly loomed large in the Fed's decision-making six years ago.

On February 4, 1994, the central bank raised the federal-funds target from 3% to 3.25%. This was the first of seven increases that doubled the target rate to 6% on February 1, 1995. Ostensibly, the Fed was conducting a preemptive strike against inflation, though the consumer price index rose by just 2.61% in 1994, and Greenspan contended that it was overstated by as much as 1 1/2 percentage points. The Fed boss did testify before the Senate Banking Committee on May 27 that he thought the average stock's price was too high. He didn't, however, indicate he would use monetary policy to fine-tune equity prices.

After the first increase in February 1994, Greenspan evidently was pleased. "I think we partially broke the back of an emerging speculation in equities," reads the transcript of the February 28, 1994, FOMC conference call. "We pricked that bubble [in the bond markets] as well. ... We also have created a degree of uncertainty; if we were looking at the emergence of speculative forces, which clearly were evident in very early stages, then I think we had a desirable effect."

Greenspan had expected that the Fed's higher interest-rate policy would reduce equity prices. According to the transcripts of the March 22, 1994, call, he told the FOMC: "When we moved on February 4, I think our expectation was that we would prick the bubble in the equity markets. ... So, what has occurred is that while this capital gains bubble in all financial assets had to come down, instead of the decline being concentrated in the stock area, it shifted over into the bond area. But the effects are the same."

At the April 18, 1994, FOMC meeting, Greenspan heralded a decrease in the financial markets' bubble. According to a transcript of the conference call, he opined, "[T]he sharp declines in both stock and bond prices since our last meeting, I think, have defused a significant part of the bubble which had been previously built up. We let a lot of air out of the tire, so to speak ...

"[The] dangers of breaking the surface tension of the markets clearly are less than they were at the time of the last meeting. ... The problem, as I've argued in recent meetings, is that we have to be careful about breaking this so-called surface tension of the market and ... selling begetting selling. That is potentially quite dangerous."

On May 17, 1994, Greenspan told FOMC members that ever since the "1987 peaks after the stock market crash," uncertainty was diminishing and there was "an element of euphoria that gripped the markets." By 1993, the transcript of the meeting states, "everybody just looked as though the markets had no downside risks ... the mere fact that uncertainty did not exist was not a good; it clearly was a bad. And our endeavor to break that pattern, which we had to do even though it turned out to be a much bigger problem than we suspected, was a very purposeful endeavor to create a degree of uncertainty and readjust holdings from weak hands into firmer hands as far as speculative securities are concerned. As a consequence, we have taken a very significant amount of air out of the bubble. ... And I think what we have reached in conclusion at this particular point is the defusion of a good part of the bubble.

"I think there's still a lot of bubble around; we have not completely eliminated it. Nonetheless, we have the capability, I would say at this stage, to move more strongly than we usually do without the risk of cracking the system."

On November 15, 1994, Philadelphia Fed Bank President Edward Boehne (a non-voting FOMC participant) summed up the Fed's actions in raising interest rates: "I think you argued rather persuasively, Mr. Chairman, that we had a bubble in financial markets and that we had to deflate that rather slowly. Otherwise we could take a big hit. In hindsight, I think that was wise."

In 1994, Greenspan twice reported the rationale for monetary policy before the House Senate and Banking Committees. These semiannual appearances at the Humphrey-Hawkins hearings would have been much more productive if the transcripts had been available on a timely basis. The vague minutes of FOMC meetings are nearly worthless for revealing individual FOMC members' responsibility for monetary policy.

In the hearings, Greenspan raised topics such as the debatable theoretical point that a low real federal-funds rate is a predictor of inflation. This served to limit questions about monetary policy from most Banking Committee members who aren't versed in economics. It's a tactic used to deflect questions about monetary policy, one that was also blatantly practiced by former Fed Chairman Arthur Burns, who used to snow Congress with five definitions of money, each in unadjusted and seasonally adjusted form.

This revelation about Greenspan's role in 1994 raises questions about what he is telling the FOMC members now. If he was trying to prick the bubble in 1994, what is he doing in 2000 when the Dow is nearly three times higher?

ROBERT D. AUERBACH , a professor of public affairs at the Lyndon B. Johnson School of Public Affairs at the University of Texas at Austin, is a former economist with the House Committee on Banking and Financial Services. He assisted in Federal Reserve oversight and hearings during the terms of four Federal Reserve chairmen.

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